Financing decision

by: Florian Voigt

Index

1. Introduction p.3

2. Financing Strategies p.4

2.1 Aggressive Financing Strategy p.4
2.2 Conservative Financing Strategy p.4
2.3 The Middle-of-the-Road Strategy/ Moderate Strategy p.5
2.4 Comparison of the Different Approaches p.5

3. Theories to Determine the Optimal Capital Structure of a Firm p.6

3.1 The Net Income Approach p.6
3.2 The Net Operating Income Approach p.7
3.3 The Traditional Approach p.7
3.4 The Contemporary Approach p.7

4. Leverage: Analysing its Effect p.8

4.1 Operating Leverage and Financial Leverage p.8
4.2 Different Degrees of Financial Leverage at a Given Level of EBIT p.9
4.3 Trade Off Between Risk and Return p.12
4.4 The Effect of Leverage on the Firm Value p.12
4.5 Factors Influencing the Choice of Financial Structure p.14
4.6 Factors to Account for before Considering Leverage p.16
4.7 Effect of debt on liquidity and solvency p.16

5. The Modigliani Miller Theorem p.17

5.1 Maximizing Firm Value vs. Maximizing Stockholder Interest p.18
5.2 Modigliani Miller Proposition I (without tax) p.19
5.3 Modigliani Miller Proposition II (without tax) p.21
5.4 Effect of Taxes p.22
5.5 Tax Shield and Present Value p.23
5.6 Value of the Levered Firm p.24
5.7 Expected Return and Leverage p.24

6. Conclusion p.26

7. References p.27
 

1. Introduction

The financing strategy is the mix of capital chosen by each enterprise (Conrad 1999:456). This strategy is of extreme importance, because it can have a profound effect on the value of the enterprise (Conrad 1999:456). In general, firms have different possibilities to design its capital structure. Debt can be issued in a large quantity or only in a small amount. Furthermore, warrants, convertible bonds, caps, callers or preferred stock can be issued. Firms can use lease financing, bond swaps or forward contracts (Miller 1988). The variations in capital structures are infinite, due to the endless number of financing instruments. Variables such as demand and supply, the capital requirement, the price of capital (interest rates), types of security, etc. are given at a particular point in time. We will discuss how a firm should finance in order to establish an optimal combination of equity and debt capital in the interests of the welfare of the owners. Uncertainty and risk are central to the financing problem and therefore financing must in essence be dynamic by nature. The single most important basis for making any financial decision is prognosis. The techniques used are mainly those of budgets and analysis by means of ratios (Lambrechts 1990: 511,512). Prognosis, income expectations and developments in the money and capital markets, play a central role as the single most important basis of each financing decision (Lambrechts 1990: 512). The optimal combinations of equity capital and debt to maximise the interest of the owners, are achieved by means of the sensible use of debt. The question thus arises to what extent this approach can be utilised and therefore the determining factors of the financial structure must be considered in more detail. This paper will focus on these factors. It will not discuss sources of financing in detail, which should be treated as a separate topic.

2. Financing Strategies

A firm can opt for one of three financing strategies: an aggressive financing strategy, a conservative financing strategy or a middle-of-the-road or moderate strategy (Gitmann 2000:619; Lambrechts 1990:513; Maness & Zietlow 1998:510).

2.1 Aggressive Financing Strategy

The aggressive strategy is used to fund at least all of the firm’s seasonal requirements and some of its permanent requirements with short-term debt (Gitmann 2000:620; Lambrechts 1990:514; Maness & Zietlow 1998:511). The aggressive strategy has a cost advantage because the financing cost of short-term debt is normally cheaper than long term debt (Gitmann 2000:622 and Maness & Zietlow 1998:512). This strategy draws heavily on the enterprise’s short-term borrowing capacity and negatively influences its liquidity (Maness & Zietlow 1998:512). Thus if an unforeseen expense comes along the firm may not be able to acquire the necessary financing for it (Gitmann 2000:622). Example: If an enterprise’s permanent financing requirement is R 14 000 and its seasonal requirements range from R 0 to R 4 000 with an average seasonal requirement of R 2 000, its financing cost is going to be:

Cost of short term financing = 4% X R 2 000 R 80.00
Cost of long term financing = 10% X R 14 000 R 1 400.00
Total cost of financing R 1 480.00

2.2 Conservative Financing Strategy

With the conservative strategy all financing requirements are financed with long-term debt and short-term financing is reserved for emergencies or unexpected outflows of funds (Gitmann 2000:622). This strategy is more expensive than the previous for two reasons: Firstly, long term financing cost is higher than short-term and secondly the firm borrows funds for the whole period regardless if it is needed (Gitmann 2000:623). Here the enterprise does not over- exceed its short-term borrowing capacity and thus it is available for emergencies (Gitmann 2000:624). The firm has excess liquidity (Maness & Zietlow 1998:512). With this strategy it is possible to reduce financing cost by reinvesting the excess amount of long term debt in the months that it is not required (Conrad 1999:456).

Example:
Using the same figures as in the above example the maximum financial requirements of the enterprise will be R 18 000. With the conservative approach the enterprise borrows the maximum amount needed during the year for the total year. Cost of financing = 10% X R 18 000 R 1 800.00

2.3 The middle-of-the-road strategy/ Moderate strategy

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